Equities, what else?

Multi Asset

Equities, what else?

We have positioned ourselves for late cycle. This means favoring equities in multi-asset strategies and portfolios.

In modern portfolio theory, a widely used concept is the efficient frontier. It comes in handy, when thinking about the current market environment. The efficient frontier is constructed by plotting all assets or combinations of assets on a chart. For each asset, the chart shows the expected return and associated risk (as measured by the variability in the resulting portfolio's return). From this, you can easily identify the assets or portfolios (taking correlations into account), which offer the highest expected return for any given level of risk. In theory, assuming there are no other options, these are the portfolios any rational investor would want to hold.

Now imagine that there is also a risk-free asset, guaranteeing a low, but certain return. The new efficient frontier becomes a straight line, stretching from the risk-free rate to the point of tangency^[1] with the portfolio set. Through quantitative easing (QE), central banks have pushed down yields on long-term government bonds, commonly used as a proxy for a country's risk-free rate. In much of the Eurozone, these rates remain close to or even below zero. Partly as a result, efficient frontiers have been lower but steeper compared to history for globally diversified multi-asset portfolios, and we expect this to persist. Therefore, constructing a portfolio with the potential to generate positive returns requires taking more risk today than in years gone by.

Still worth taking risk

For now, we think it is still worth taking risk. We mainly do so through equities. At the same time, it is important to monitor overall portfolio risk and ensure that risks are managed properly. Equity valuations are stretched but still not too high in our opinion to justify further gains. After all, earnings are growing solidly. There is hardly any alternative to equities to generate reasonable returns, not least as they are a lot more liquid than high-yield credit, for example. On the fixed-income side, we expect rates to stay rather low, with the yield curve flattening. This reflects our view that the market has entered a late-cycle phase. Within fixed income, we particularly like high yield and generally prefer emerging-market over developed-market debt. Debt levels are going up, especially in the United States, but they are also underpinned by strong earnings. As for gold, we do not expect massive upticks in real rates, which would raise the opportunity costs of the precious metal. Gold remains one of the preferred assets to diversify multi-asset portfolios against event risks.

Enjoy it while it lasts

Our positioning is predicated on the benign macro-economic environment we expect for the next 12 months. Global growth has lately become very broad-based. Meanwhile, inflation remains dormant in most countries. This should continue to limit pressures on central banks to raise interest rates too quickly. QE looks set to peak towards the end of 2018, however. That might also be a turning point in the cycle given the impact monetary policy has had on asset prices in recent years. Investors' demand for both capital growth and income from coupons and dividends is likely to remain high as we expect monetary policy to remain loose for the time being.

Which brings me back to the efficient frontier. Due to QE, a lot of investors have been forced to take more risk than they might have previously felt comfortable with. In anticipation of less accommodative monetary policy, we might eventually move from a low- to a medium-volatility regime. Risk measures relying on volatility numbers for the last couple of years might prove misleading. Notably, they are likely to understate the potential impact from events we currently assign low probabilities to. Such events include a recession suddenly materializing or a surprising increase in inflation, perhaps accompanied by some kind of policy mistake by central banks. We could also see increasing divergence of central-bank policy between the Fed and the ECB with respective implications for core interest rates as well as the EUR/USD exchange rate. Sharp policy shifts or geopolitical escalations could lead to temporarily higher volatility. For now, such a temporary uptick in volatility is unlikely to be a game changer. All told, we expect the currently low volatility to last longer, potentially for another 12 to 24 months.

Lower returns ahead

We expect efficient frontiers to be lower but steeper for globally diversified multi-asset portfolios than has historically been the case.

2017 has been an unusual year

Across a wide range of asset classes, maximum drawdowns (the fall from peak to trough) have lately been well below historic averages.

Allocation

Taking risks the right way

Diversification is getting ever harder in traditional asset classes.

Equities remain our preferred choice among higher-risk asset classes. Tactically, we note that sentiment and positioning have become more bullish. This suggests scope for setbacks, but fundamentals remain solid. We generally prefer regional equity exposure outside the United States, due to lower valuations and better earnings momentum elsewhere, notably in Asian emerging markets. We retained exposure to commodities sensitive to global growth, believing they have the potential to rise further. Developed-market credit, in particular high yield, looks increasingly vulnerable to any market correction. Overall, it is hard to find diversification in traditional asset classes these days. Hence, we built up exposure in diversified alternative strategies.

The chart shows how we would currently design a balanced, dollar-denominated portfolio for an Asian investor taking global exposure. This allocation may not be suitable for all investors. Alternatives are not suitable for all clients.

Indicators

Mostly sunny

Indicators continue to signal an excellent environment for capital markets.

For months, indicators have signaled a very positive market environment, and this is due mainly to two factors: first, investors appear to have gotten used to geopolitical risks and have tended to shrug them off; and second, ever larger swaths of the global economy are currently growing in sync. This has further strengthened capital-market participants' confidence. Consequently, the macro indicator has climbed considerably again.

However, continuing positive economic data had already boosted analysts' expectations before the summer. This increased the potential for disappointment, and the surprise indicator temporarily slipped into negative territory. Since then, expectations have moved back in line with reality. As a result, there have been more positive surprises. The surprise indicator has gone up continuously since the end of June. The sub-indicator for Europe even marked a new all-time high in October. The risk indicator reflects investors' most recent extremely high risk appetite; in October, it reached its highest level since 2012. This was accompanied by a mainly positive stock-market performance. All three multi-asset indicators are currently in positive territory, as they have mostly been thus far this year.

Macro indicator

Condenses a wide range of economic data

Risk indicator

Reflects investors’ current level of risk tolerance in the financial markets

Surprise indicator

Tracks economic data relative to consensus expectations